An Atypical Strategy For Aging Medical Office Buildings

With the day-to-day stress of making a medical office building run, a very basic, crucial consideration might be slipping by, unnoticed: what to do with the aging building? Neglecting wear and tear could mean even a successful property will see its returns diminish. It might be time to consider the sale-leaseback writes Transwestern SVP of healthcare real estate Brent Barnes in this EXCLUSIVE commentary for GlobeSt.com.

The views expressed are the author’s own.

Hospital administrators are often vexed by the older medical office buildings (MOBs) they own, unsure how to address the properties’ increasingly outdated appearance, perhaps exacerbated by deferred maintenance. Were the structures in pristine condition, the owner would most likely have already monetized the assets through a partial or full sale-leaseback, a transaction type that grew popular in healthcare real estate over the past decade.

In a sale-leaseback, an outside landlord purchases the property and leases it back to the seller. This generates sale proceeds for the seller while the buyer gains a fully occupied building with a rental income stream guaranteed for the duration of the lease. MOB sale-leasebacks have averaged a 7.0 percent capitalization rate for the new landlord, or a 7.0 percent annual rate of return on the acquisition price.

Sale-leaseback buyers prefer buildings that can command market rents with little up-front investment beyond the acquisition price. Cosmetic flaws such as outdated lobbies, restrooms and corridors, a lack of modern technological infrastructure and similar drawbacks can impede a landlord’s ability to demand market rents. Correcting these problems would increase the owner’s cost and diminish overall returns.

This seems to limit the options for hospital systems with older, owned buildings requiring renovation, and further delay will compound the problem. Healthcare providers know that patients – especially those in the millennial generation – expect to receive treatment in attractive buildings with bright, welcoming interiors. At some point, failure to renovate will drive patients and tenants to competing providers that offer more modern facilities.

Let’s Make a Deal

The hospital owner in this position has a viable option to retrofit the building and monetize the asset through a sale-leaseback. Here’s how:

Plan upgrades.

Design a realistic renovation that will put the building on par with competing properties, able to attract tenants and charge market rent. Then prepare a detailed cost estimate and timeline for the work. A healthcare real estate advisor can assemble and direct a team to complete this process, working with an architect, building contractor and other experts.

Price to sell.

Rather than setting an asking price at the market’s current capitalization rate of approximately 7.0 percent, structure a transaction in which the buyer purchases at an 8 percent cap and require the buyer to invest that money into the needed capital improvements. For example, an owner might drop a building’s asking price from $30 million to $25 million. That $5 million margin will enable the buyer to make the required asset upgrades and still achieve a healthy overall return.

Structure and close the deal.

After marketing the offering as a package contingent on the renovation and capital improvement plan and selecting a buyer, be sure to include language in the transaction documents binding the new owner to complete the improvements according to schedule. For example, the buyer may commit to upgrade restrooms and corridors within 24 months and renovate the lobby the following year.

Including a detailed renovation plan in the offering and selecting a capable buyer to execute the improvements can turn a tired MOB into a modern, patient-centric care center that helps both the hospital system and the new landlord meet their objectives.